By HENRY MCVEY Sep 08, 2015
We are adding two percent to our U.S. Equity position, lifting our weighting to 22% from 20% and a benchmark of 20%. This increase now takes our overall Global Equity allocation to above benchmark for the first time this year, with a notable overweight to developed markets relative to an underweight in emerging markets. See the following pages for specific details, but we fund this increase in U.S. Equities by reducing the cash balance we elected to build up in January 2015. From a cyclical perspective, we see negative sentiment, decent — albeit unspectacular — EPS growth, and reasonable valuations as signals to “Lean In” to certain parts of the U.S. market. Probably more important, though, is the positive secular case we now see unfolding for the United States. Indeed, the long-term outlook for the U.S. consumer has improved materially in recent quarters, and we now see more gains ahead, particularly around household formation. Meanwhile, Corporate America is increasingly leveraging its “Made in America” innovation across a variety of sectors, including Healthcare, Technology, and Energy Services, to distance itself from its global peers. Against this constructive macro backdrop, our allocation framework now argues for an increased weighting on both a short-term and long-term basis to the United States.
In January 2015 when we decided to raise our Cash allocation, reduce our overweight to Global Equities for the first time since 2011, and tilt the portfolio more defensively (see Getting Closer to Home), we did not foresee something akin to what happened on Monday, August 24th, when the market essentially went into a technical free fall, as VIX spiked to 40.7 from 13.0 just seven days prior. However, after six straight up years in the U.S. equity market amid near record low volatility, we did have enough good sense to know that it was not the time to stretch for equity returns – despite an improving outlook for the U.S. economy relative to its global peers, China in particular.
Today, we see the world differently. We no longer believe investors should get “Closer to Home.” Rather, with the global capital markets quite unsettled, we want to begin the process of “Leaning In” by allocating more incremental capital back towards risk assets, particularly in the U.S. To this end, we are making the following two changes to our target asset allocation (see Exhibit 3 for full allocation details):
- We are reducing Cash to 1% from 3% versus a benchmark of 2%. With prices down and volatility up, we now feel compelled to start to spend some of the “rainy day” funds we husbanded back in January. Implicit in our decision is our view that, while the equity cycle is mature, it is not yet over. Further details below.
- We use our cash proceeds to boost our Global Equity allocation to overweight from equal weight by raising our U.S. Equity allocation to a 22% weighting, compared to 20% previously and a benchmark weight of 20%. We retain our one percent overweight to Asia (with focus on Japan) and our two percent overweight to Europe, offset by our two percent underweight to Latin America, Brazil in particular.
We note three tactical considerations that we think are worthy of investor attention as one considers bolstering his or her equity position in the United States at this point in the cycle. They are as follows:
- First, as we describe below in great detail, our proprietary KKR Equity Capitulation Index reflects our view that the U.S. equity market is now clearly oversold. In the past, particularly around the sovereign crises of 1998 and 2011, the indicator gave important buy signals when it spiked to the levels the market just recently experienced.
- Second, 67% of the U.S. earnings this year will come from Consumer Discretionary, Financials, Technology, and Healthcare. We generally feel good about the sturdiness of these earnings streams as we head into 2016, a belief that is confirmed by our proprietary KKR Earnings Growth Leading Indicator (Exhibit 9).
- Third, valuations are now reasonable to attractive in many sectors after the recent sell-off (something we were not saying back in January). Specifically, the S&P 500 was trading at 16.4x trailing earnings at the end of August 2015, compared to 17.3x in early January 2015, a peak this year of 17.9x in May 2015, and a long-term average of 15.7x since 1965.
While we expect there to be plenty of debate around whether to add to U.S. Equities at current valuations, at this point in the cycle, we think that the long-term outlook for the United States has become much less controversial, particularly relative to its global comps. Indeed, at a time when the China Growth Miracle that defined the 2000-2010 period is waning (see China’s Rebalancing Effort: Will It Be Enough), we see the U.S. gaining increasing stature as an investment destination of choice. Consistent with this view, we see five large scale investment opportunities that we think will garner an increasing proportion of capital flows and investor attention over the next few years:
- U.S. household formation is breaking out; invest behind this development. Key sectors that should prosper include housing, multi-family rental, home repair, etc. (See March 2012 Insights note U.S. Housing: A Changing Dynamic). Importantly, as we detail below (Exhibit 49), we recently again revised upward our housing start forecast as part of this deep-dive on U.S. fundamental growth drivers.
- While we do not see a major shift in consumer preferences towards higher-end products, we do expect more consumer spending in many areas, including recreation, beauty, and wellness. As we detail below, consumer “experiences” are taking precedence over “things” – a trend we expect to continue at an increased pace. Also, given that we look for little improvement in productivity, we expect strong employment growth trends to continue in the United States. If we are right, this trend is constructive for broadening spending patterns in the U.S.
- U.S. non-cyclical, growth stocks, particularly in Healthcare and Technology, should continue to appreciate. We acknowledge that near-term valuations are stretched in certain instances, but we like big market opportunities like diabetes/insulin delivery, immuno-oncology, and cyber security. Given its proximity to Mexico and Canada, we also think that the United States is reestablishing itself as a compelling place for re-shoring initiatives. We do not see a true “manufacturing renaissance,” but believe there are some noteworthy tailwinds that now warrant investor attention.
- We expect U.S. Financial stocks to perform well too. In particular, we favor domestic banks, insurance companies, and card companies that should benefit from better credit conditions, loan growth, and lower legal costs. Consistent with this view, mortgage credit and asset-based lending should perform better than current expectations, particularly if we are right that long-term rates remain low. Importantly, though, we focus on financial companies with aggressive capital management programs because we do not expect to be bailed out by higher short-term rates surprising on the upside in late 2015/early 2016 (Exhibit 10).
- Our “value” idea for the U.S. equity market centers on the Energy sector, which is suffering from an overhang of excess capacity and capital. With valuations down meaningfully, however, we think that now is the time to begin the search for long-term winners amid the rubble. In particular, it appears that in certain instances the market is not discerning properly between low-cost and high-cost producers as well as between recurring revenue infrastructure stories and more speculative exploration and production names. Also, as we describe below in more detail, we think that convertible securities in the energy arena could at times be a more efficient way to play this “value” investment theme in Energy.
To be sure, there are risks to our re-allocation. U.S. Corporate margins have likely peaked, mergers and acquisition trends appear frothy, and financial conditions are now less favorable. Also, one – if not the major force in global quantitative easing (QE) – is poised to shift course by raising rates sometime in 2H15. Unlike at the beginning of the year, however, we now think many of these risks are more appropriately priced into U.S. stock prices at current levels.
Looking at the big picture, we want to underscore that our overall allocation message is not “All In.” Rather, we are “Leaning In” towards specific pockets of strengths, as we still think that there are some important macro crosscurrents unfolding around the globe that are worthy of investor attention. First, we think we remain stuck in an asynchronous recovery, with lack of global demand from the developed markets weighing on the virtuous “cycle” that defined the economic recoveries of the 1990s and 2000s. Indeed, as Exhibits 1 and 2 show, global trade as a percentage of GDP has peaked at a time when DM savings are up and EM exports as a percentage of GDP are falling. Importantly, weakened EM currencies are not helping exports; rather, they are only denting imports, further pressuring global trade.
The Big Headwind: Global Trade Is No Longer the Growth Engine It Once Was
DM Belt-Tightening Has Become a Headwind to Trade-Driven EM Growth
Second, as our asset allocation underscores, we are now notably overweight developed market equities at the expense of developing market equities. Importantly, though, this viewpoint is consistent with the work we laid out earlier in the year (Emerging Market Equities: The Case for Selectivity Remains), which showed that EM underperformance cycles typically last 91 months or 7.6 years, on average, compared to the current length of “just” 59 months.
Third, as we lay out in this paper, we think that the U.S. has now emerged as an important and favorable investment destination for long-term patient capital. Central to our view is that the U.S. consumer, having paid down debt and increased savings, is now in much better shape. If we are right, this viewpoint has significant implications for global flows across the currency, stock, and bond markets.
Fourth, we think the China fixed investment slowdown has yet to fully play out. True, growth in year-over-year fixed investment is down to “just” 11% in 2015, compared to almost 34% year-over-year in 2009. However, we still see more downside ahead as the government tries to bring nominal lending growth below nominal GDP. Somewhat ironically, though, we actually look for China’s trading partners to perform worse than China as the duo of slowing growth in Chinese fixed investment and lower commodity prices all weigh on growth – and returns. Importantly, China’s recent decision to reduce the value of its currency means that China’s improved competitiveness will likely come at the expense of some of its biggest trading partners, Southeast Asia and Latin America in particular.
No doubt, given all these crosscurrents, we acknowledge there is certainly risk to moving back towards a slightly more pro-cyclical tilt in our asset allocation. However, we think we mitigate any potential issues two ways. First, as our asset allocation targets show in Exhibit 3, we still retain a massive 15% overweight to Distressed/Special Situations, which we think should continue to thrive amid the dislocations we are seeing across many emerging markets these days. Second, if China and its EM peers do create some form of global contagion, we think the U.S., with 70% of its economy linked to the consumer, will be more insulated than many in its peer group. Please see Section II: Risks to Our Call for further details.
KKR GMAA 2015 Target Asset Allocation Update
Section I: Why We Are Moving To an Overweight Position in U.S. Equities
We see several reasons to bolster our U.S. Equity position in the near-term. First and foremost, if we adhere to the old adage to buy fear and sell greed, we note that our proprietary KKR Equity Capitulation Indicator, which we detail in Exhibit 4, suggests that investors should now be deploying capital into the current capital markets dislocation.
For those who have not seen our indicator before, it looks at how many standard deviations dislocated the market is versus the 24-month trailing average on a variety of momentum and breadth metrics, including things like price momentum and number of companies trading well off their one-year highs. Somewhat shockingly, the indicator is currently registering its second worst reading over the past 20 years at -2.7. The only worse incident was in August 1998, when it registered -3.2.
Importantly, though, the reason why the indicator is down so much—even though the market has fallen “just” 12% from the highs—is that the current sell-off is taking place in the context of what had been an extremely low-volatility environment of steadily rising prices. As such, the current shock looks quite pronounced relative to the historically placid market of the past two years, suggesting that the market is going to need some time digest and re-calibrate. Put another way, we think we have put in a bottom, but we also believe that some time is required for the market to heal after August 2015’s outsized macro shock.
While there are many historical equity sell-offs to which one could compare the current one, we think the 1998 and 2011 downdrafts present some of the most interesting analogies. The common factor that unites these prior episodes with the current one, we think, is that both were non-recessionary market crises that took place in the context of a healthy or healing U.S. economy and were spurred by international conditions.
Our KKR Equity Capitulation Indicator Suggests That Now is a Good Time For Long-Term Investors to Lean Into U.S. Equities
What did we learn by looking at prior instances? Well, for starters, we found some spooky echoes around the timing of all these events. Each crisis kicked off within a narrow late-July window. This year, the market peaked on July 20. In 1998, the peak was July 17. In 2011 it was July 22. Interestingly, in both prior incidents, things ultimately bottomed out in early-October, with the market down 18-19% peak-to-trough (Exhibit 5).
The pattern has been for the market to quickly make a low, then spend some time bouncing around that low for a while. So, if the historical analogs hold, we should expect that the market made its lows in late August (the prior incidents made an initial low around 20-30 days into the sell-off), but will remain volatile in coming weeks and perhaps re-test the lows sometime before early October (the prior incidents tested a final low around the 50-60 day mark).
In terms of S&P 500 valuation compression, in both prior incidents P/Es lost 2.3-2.6 multiple points at the troughs, versus -0.9x currently. As such, based on price and valuation, these analogs would argue that the market needs to fall another 7-10% beyond the current drawdown of about 12%. However, our “gut” is that this is too punitive, in that the prior incidents were defined by clear and present sovereign default risks (Asian crisis in 1998 and Europe in 2011).
Bears will argue that lower commodity prices and China’s slowing are signaling the end of the cycle. We are certainly sympathetic to the contagion effect of secular decline in China’s fixed investment (see our note Emerging Market Equities: The Case for Selectivity Remains), but we do not think it will be broad-based enough to derail all the positive momentum we see in the U.S. consumer, despite the absence of rate cuts (Exhibit 7).
In the 1998 and 2011 Market Crises, the S&P 500 Troughed Around -18 to -19% After 50-60 Trading Days
S&P 500 Has Currently Lost 0.9 Multiple Points, Versus 2.3 and 2.6 Point Losses in 1998 and 2011, Respectively
Similar to 1982 and 2001 in the U.S., Private Consumption Could Act as an Important Offset in a Global Economic Downturn
In 2015, Consumer Discretionary, Healthcare, Info Tech and Financials Account for Fully 67% of Bottom-up EPS Growth
Our Earnings Growth Leading Indicator (EGLI) Is Pointing to Modest But Positive Growth Over the Next Twelve Months
When analyzing the outlook for the U.S., we also take comfort that the lion’s share of earnings growth in the near-term comes from sectors that we think can withstand the ongoing contraction out of the emerging markets.
Consistent with this view, our proprietary leading indicator for earnings growth in the U.S. points towards modest, but fairly secure earnings growth over the next 12 months. One can see in Exhibit 9 that our indicator suggests EPS growth of 5.6% year-over-year for the 12 months ending August 2016. Not surprisingly, lower oil prices should start to benefit the consumer by mid-2016, helping to offset some of growth drag we anticipate from wider credit spreads amid tighter financial conditions.
Finally, if market volatility persists in the coming weeks as we outline above, we think the Fed is likely to ease market conditions a bit by delaying its first hike to December versus our prior base case of September. That said, there is little change to the overall shape of our expected Fed Funds curve, which we now think peaks at 2.375% in 2017 (Exhibit 10), down only slightly from 2.5% previously. The implications for our U.S. 10-year yield forecasts are similarly mild, as we move our year-end 2015 target to 2.4% from 2.6% previously. Importantly, though, we hold our 2017 cycle-peak target unchanged at 3.0% (Exhibit 11).
Our Expectations for Fed Rate Hikes Are Below the FOMC Forecast, But Above Current Market Pricing
We Lower Our 2015 U.S. 10-Year Target to 2.4% from 2.6%, But Maintain Our Cycle-Peak Target of 3.0%
Section II: Risks to Our Call
Without question, there are risks associated with our decision to add to U.S. Equities, and to be sure, we are not suggesting that this is the beginning of a new bull market. In fact, many of the issues that we highlighted in our 2015 Outlook piece still warrant investor attention. We note the following ongoing concerns:
Point #1: Even With the Recent Sell-Off, Equity Market Returns Appear Robust Relative to History
An important performance enhancer this cycle has been significant multiple expansion, which is now in line with historical averages of around 41-42%. Moreover, consistency too has been stellar, as the index has appreciated six consecutive years (Exhibit 12), which is quite rare by historical standards.
U.S. Equity Performance This Cycle Is Well Above Historical Norms
If the S&P 500 Delivers Another Positive Year in 2015, It Will Be Highly Unusual Relative to History
Moreover, it has done so with essentially no volatility – until recently. Just consider that through July 31, 2015 the two-year trailing Sharpe ratio (i.e., return per unit of risk taken) of the S&P 500 stood at 1.76. This low level is more than one standard deviation above the long-term average of 0.73. For the most part, as shown in Exhibit 15, we attribute this strong risk-adjusted performance to unusually low levels of volatility. In fact, the trailing two-year average volatility of the S&P 500 stood at 9.0%, which is over one standard deviation lower than the long-term average of 14.3%. We attribute this unusual and in our view unsustainable level of volatility to the massive amount of liquidity in the system driven by Fed policy.
Until Recently, Current Market Conditions Have Been Ideal…
…In Large Part Due to Repressed Volatility, Driven by Extraordinary Monetary Policy
Point #2: Certain Parts of the U.S. Capital Markets Appear to Be Extended
With quantitative easing (QE) pushing real yields towards record lows, folks should not be surprised that the Federal Reserve has been successful in forcing investors to move further out along the risk spectrum in search of higher yields and more robust total returns. This re-allocation by investors towards “spicier” assets is also consistent with the central bank’s goal of debt reduction via driving nominal interest rates below the nominal GDP growth rate.
However, in suppressing rates, the government has all but ensured that every M&A transaction today is accretive. Not surprisingly, as we show in Exhibit 16, CEOs have responded by acquiring competitors at a torrid clip. If current trends persist, 2015 activity will be at levels commensurate with other prior peaks, 2000 and 2007 in particular.
M&A as a Percentage of GDP Suggests We Are Now Approaching Peak Levels
Several Capital Markets Indicators Have Turned Frothy in 2015
Point #3: Monetary Policy Is Finally Changing Direction
After nearly $4 trillion of quantitative easing initiatives since 2007, the Federal Reserve has finally begun to become less accommodative. To be sure, liquidity conditions are still quite robust. However, in our view, marginal change is what often matters the most, and right now the Fed’s balance sheet is pivoting away from accumulating assets. This view is significant, as the stock market and the Fed’s balance sheet have exhibited highly similar trends since 2009. In fact, Exhibit 19 shows that their year-over-year growth has been 40% correlated since 2008, with the S&P 500 typically anticipating the Fed’s movements by about one quarter.
Rate Increases Typically Dent Equity Performance at Some Point
Excess Liquidity Has Been Highly Correlated to S&P 500 Performance in Recent Years
Not surprisingly, given this shift in the Fed’s posture, financial conditions in the United States have started to become less accommodative. One can see an expression of this increased tightness in Exhibit 20, which has clearly affected S&P 500 equity performance. Importantly, against this backdrop of tighter conditions, we also believe that default rates are poised to head higher. The catalyst, we believe, will likely be the Energy sector, given that there was a sizeable $210 billion of energy high yield credit issued in 2014 versus just $55 billion in 2005 (Exhibit 21). Consistent with this view, we note that, as Exhibit 22 shows, the trailing 12-month default rate for high yield typically runs below average for 55-58 months before default rates start picking up. As we are 54 months into the cycle, some mean reversion towards the long-term average of 4.5% is likely in the coming months and quarters ahead, we believe.
Financial Conditions Have Turned Tighter In Anticipation of the Fed Tightening
High Yield Energy Net Issuance Is Up 4x Over the Past Ten Years
While we acknowledge that the Federal Reserve will be quite measured in its tightening cycle, higher short-term rates generally signal the beginning of the end of a bull market. One can see the historical basis for this argument in Exhibit 18. Importantly, while the historical data in this exhibit suggest that the average bull market has peaked 30 months after the Fed began tightening, we actually think it could be sooner this cycle. Why? At the risk of pointing out the obvious, the Fed is starting its tightening campaign much later this cycle than in the past. We also note that, if we exclude long cycles that defined the Great Moderation during the 1980s, 1990s and 2000s, the average market peak is closer to 16 months after the first Fed hike.
The Current Credit Cycle Appears Well Advanced; We See More Defaults Ahead
Point #4: U.S. Corporate Margins Recently Peaked at High Levels
As Exhibits 23 and 24 show, net margins in the United States are now quite high relative to trend. To be exact, they are now 38% above trend, which is seemingly robust – even if bulls are right that we are in a new regime for corporate profitability. In fact, only the Healthcare and Telecom sectors have industry margins that are technically below trend, though we acknowledge that the recent sell-off in oil will push this sector back below trend profitability in the near term.
S&P Margins Appear to Have Peaked
S&P 500 Sector Margins as of 2Q15
Point #5: Length of Cycle: We Are Now 75 Months Into a Recovery
While memories of the Great Recession still tend to haunt many investors in one form or another, the truth is that the March 2009 bottom was a long time ago. So, it might come as a surprise to some folks that the duration of the current U.S. economic expansion is now a full 75 months, well above the historical median of 37 and essentially on par with the 2001-2007 expansion. One can see this comparison in Exhibit 25.
We Are a Solid 75 Months Into the Current Economic Expansion
Our Analysis Shows That, Based On the Amount of Easing by the Fed, This Economic Cycle Could Run Until 2017
No doubt, as we lay out quantitatively in Exhibit 26, the sheer amount of liquidity injected into the system should have helped to extend this cycle relative to past ones. However, even with this boost, our work shows that the recent 150% increase in the U.S.’s monetary base stretches the current economic expansion to extend to around 100 months. This quantitatively driven judgment makes sense to us as it is about in line with our fundamental forecast of the cycle extending into 2017 (95 or so months).
Bottom line: In addition to the concerns we have highlighted surrounding weak global demand and China slowing (Exhibits 1&2), the U.S. faces its own internal challenges, five of which we have detailed in this section on risks. Not surprisingly, many of these macro concerns can be linked to the ‘traditional’ excesses that begin to occur later in a U.S. cycle.
That said, our work shows that the cycle is not over; moreover, our quantitative and fundamental analyses suggest that poor sentiment and improved valuations, coupled with what we believe will turn out to be decent earnings growth over the next 12 months, argue that we should use the current pullback to “Lean In” to U.S. Equities.
Section III: Why We Are We More Constructive on the Long Term for the United States on Both an Absolute and Relative Basis
In any moment of decision, the best thing you can do is the right thing, the next best thing is the wrong thing, and the worst thing you can do is nothing. Theodore Roosevelt
When one reflects back on the 2002-2007 period in the United States, it seems like at every “moment of decision,” Americans did everything but the “right” thing. Wall Street took on too much leverage, the government eased regulation when it should not have, and consumer spending became excessive. Whether intentional or not, this economic “game plan” certainly dented America’s standing in the global economy coming out of the Great Recession, and not surprisingly, it has taken years to repair the reputational damage incurred from misguided policies and procedures.
If there is good news, it is that America was not in the camp of doing “nothing” after its fall from grace. Rather, the United States has taken some bold steps to revitalize and reposition its economy. In particular, the U.S. consumer has gotten back into “fighting shape,” having paid down debt, built up savings, and spent less. This restocking exercise by John and Jane Doe matters a lot, given the consumer is the swing factor in the U.S. economy. It also stands in sharp contrast to what has happened to the local consumer in many emerging countries. Indeed, in Brazil, consumer credit grew by 47% from 2010-2014, compared to just a 2% increase in the U.S. during the same period. Beyond the consumer improvement story, the U.S. has built what we view as competitive advantages in several key growth industries.
To this end, we thought it might make sense to lay out why we believe that the U.S. has emerged as a compelling destination for capital over the next 5-7 years.
Reason #1: U.S. Consumer Is Coming Back, Albeit With Unique Preferences This Cycle
At the risk of oversimplifying the U.S. economy, 70% of it is linked to U.S. consumer spending, and we think spending is headed higher. Indeed, after years of belt tightening and debt reduction (what one European client identified as “very un-American behavior”), our work points to three notable areas of improvement. First, the consumer debt burden is as low as we have seen it in years. As Exhibit 27 shows, revolving credit reached just 26.5% of total consumer credit in June 2015, down nearly 28% since 2008.
Second, as we show in Exhibit 28, the American savings rate has been replenished back towards the upper end of its range. Besides saving more through their income statements, Americans are also enjoying significant increases in net worth as the prices of their homes finally rebound. According to CoreLogic’s 1Q15 Equity Report, 1.2 million Americans regained equity in their homes in 2014. As such, CoreLogic reported that the total number of mortgages with positive equity increased to 44.9 million, or 89.8% of all mortgaged properties, compared to just 38.1 million or 78.5% in 4Q12.
70% of the U.S. Economy Is Actually in Pretty Good Shape
The Savings Rate Today Is Now on Par with the Beginning, Not the End, of the 2003-2007 Cycle
Third, while recent wage growth data has been disappointing, we do expect wages to tick up at this point in the cycle. One can see in Exhibit 29 that the cyclical metrics of the labor market, such as average monthly non-farm payroll growth, are now indicating that the labor market is nearing “full capacity.” Furthermore, based on some proprietary work by my colleague Jaime Villa, we think the recent uptrend in the government-calculated employee cost index should spill over into average hourly earnings metrics by the fourth quarter of 2015. The direction of our analysis can be seen in Exhibit 30.
From A Cyclical Standpoint, the Labor Market Appears to be Nearing Full Capacity
We Also Think Wage Growth Is Starting to Tick Up and Could Firm Up Nicely by 4Q15
Reason #2: Household Formation Is Finally Rebounding
As we have watched most of this recovery unfold from our macro perch at KKR, one of the most perplexing – and disappointing – trends has been the slow rate of household formations. Specifically, household formation has been averaging 990,000 per year since 2007, even though it theoretically should have been closer to 1.39 million if the percentage of adults who head their own household (i.e., the “headship rate”) had only held constant. Instead, the national headship rate fell, and as we show in Exhibit 31, the decline was particularly notable among 25-34 year-olds, where it fell fully 300 basis points from 2007-14. All told, we calculate that roughly half of the apparent shortfall in U.S. household growth in the post-crisis era is explained by the “missing” household formations among this key first-time homebuyer demographic of 25-34 year olds.
Household Formation Has Been Notably Slow in the Post-Crisis Era, but We Think the Trend Is Now Finally Improving
A Collapse in Household Formations by 25-34 Year-Olds Was a Key Reason Why Household Growth Has Been So Slow
All told, this cumulative “shortfall” of 400,000 households per year—or 2.8 million in total—from 2007-2014 is a big deal, in our view. Household formation has traditionally served as an important catalyst for transitioning an economic recovery into a self-sustaining economic expansion. As we show in Exhibit 52, the multiplier effect on the economy from a healthy housing market greatly exceeds the benefits of the wealth gains passed from the stock market. Specifically, we think that the consumption pass through from incremental housing wealth averages a full 6.5-6.8%; by comparison, the stock market averages 2.8-2.9% or less than half that of housing.
As we look ahead, the good news is that the rate of household formation has finally started accelerating. Indeed, in the 12 months ended June 30, 2015, there were fully 1.618 million household formations. We suspect the recent pace of improvement is not sustainable, but we do think we are entering a new era of robust household formations that are supported by a healthy job market and healing consumer credit. As we outline in Exhibit 31, we estimate that there will be about 1.55 million new household formations annually through 2020 if headship rates can only stabilize at current levels.
Bottom line, we think we are seeing a transition from a financial wealth effect-driven, QE-led recovery to potentially an income-related one that has the potential to broaden into the most important domestic cycle industry in the United States, housing. If we are right, then this transition has significant implications for consumer spending, particularly among the millennial generation.
Reason #3: The Current Low Long-Term Rate Environment to Continue
While we do expect short-term rates to move up and the yield curve to flatten over time, our base case is that the long end of the market stays at favorable levels. This viewpoint is significant because it sets the backdrop for an extended period of solid financing in the corporate side, and it makes mortgages still very affordable on the consumer side, we believe.
So, why do we have so much conviction that long-term rates will remain well behaved? We note the following:
- As we show in in Exhibit 34, over the long term, 10-year rates tend to move closely with the nominal GDP growth trend, which we think is now structurally slower.
- As we show in Exhibit 35, labor force growth, which is now less robust in the U.S., tends to move hand-in-hand with long-term rates.
- Given the sizeable quantitative easing program being implemented in Europe, we do expect German bunds to remain at low levels. Our year-end forecast is around 100 basis points. So, if history holds, then the U.S. Treasury should not trade more than 150-200 basis points above the bund. One can see this in Exhibit 36.
- We are increasingly of the mindset that China is exporting deflation, which should help to keep a lid on global bond yields. Indeed, with its producer price index now negative for 41 months, China appears to have an excess capacity problem. To this end, we are not surprised that the government recently announced the unpegging of its currency against the U.S. dollar in an effort to improve its standing in the global export economy. The stronger U.S. dollar also lowers imported inflation risk.
- Against a backdrop of low commodity prices and excess capacity, we expect the Federal Reserve to move slowly. In our view, a slower cycle on the short-term likely helps to anchor the long-end as well.
If there is a risk to our view that rates move up modestly, we think it is linked to the potential for foreign central banks to begin selling more dollar based reserves. To date, selling pressure in U.S. Treasuries has been modest. However, should local EM currencies continue to depreciate sharply, then there is risk to our forecast, we acknowledge.
We See Yields Staying Pinned a Little Lower Than We Originally Expected, Though Our 2017 Forecast Remains Unchanged
Nominal Long-Term Rates Are Highly Correlated With Nominal GDP Growth
There Is a Strong Historical Relationship Between Demographics and Inflation
In Addition, Europe QE Is Currently Acting as an Anchor for U.S. Rates
Reason #4: Less Government Drag
Often we hear from investors that the U.S. economy is not what it used to be in terms of growth. No doubt, there has been a downshift, but sometimes what gets lost in the discussion is the bifurcation between the private sector and the public sector. As Exhibit 38 shows, the private sector has actually been growing closer to 3.0% since 2010. However, because of significant fiscal belt tightening within the government’s ranks, overall reported GDP trends have been notably worse. One can see this magnitude of the fiscal drag in Exhibit 37.
Developed Market Fiscal Drag Is Now Finally Waning
Real Private Sector GDP Has Been Strong for Some Time, but the Government Is Now Finally Becoming Less of a Drag
Importantly, as we look ahead, the good news is that the fiscal overhang is expected to be zero by the end of 2015, down a full 180 basis points versus 2013. Given there is typically a 50-75 basis point multiplier on GDP, this reduction in belt-tightening could be a notable positive for overall GDP growth in 2016 and beyond. This reduction in government drag is also important because it broadens the growth drivers in the U.S. economy, putting less pressure on the private sector to consistently over-achieve each and every quarter.
Reason #5: Innovation/Ease of Doing Business
Apple Corporation founder Steve Jobs was once quoted as saying that “innovation distinguishes between a leader and a follower.” From almost any vantage point, one would have to consider the United States under Jobs’ definition as a clear “leader” — not a “follower” — with notable positions in technology, biotechnology, and energy.
How strong is the U.S. today relative to its peers? Well, just consider that in the Technology sector, the equity market capitalization of U.S. Technology stocks in the S&P 500 stands at nearly $4 trillion or 19.8% of the entire market capitalization of the index versus just $337 billion, or 3.4% of the index of the MSCI Europe Index. One can see this in Exhibit 39. Moreover, many leading technology companies are staying private for longer, which suggests the U.S. total may actually be understated.
Europe’s Value Creation in Technology Has Badly Lagged the United States
Technology Is Reducing the Need for Traditional Capex
Another key point about the U.S. technology effort is the important role that software has played in facilitating the transition towards a services economy. As we show in Exhibit 40, software is now a larger percentage allocation of total fixed investment in the United States than traditional capital goods.
Meanwhile in healthcare, the U.S. is among the top global players in all aspects, including basic science, diagnostics, and therapeutics. One particular area of focus with investors of late has clearly been biotechnology, which has enjoyed a surge in drug approvals and value creation in recent years. One can see this in Exhibits 41 and 42, respectively.
New Molecular Entity Approvals Are Nearly Double the Average Since 1940
Though There Has Already Been Significant Value Creation in Biotech, We See More Ahead
Finally, in energy the story of American innovation as it relates to the “shale revolution” is well documented, so we will not spend too much time explaining the technological advances that have been made through both horizontal drilling and hydraulic fracking. That said, we want to underscore what these technological advances have meant to both liquid production as well as dry natural gas production. Simply stated, they are “game changers” in terms of both American independence and productivity. Indeed, as Exhibits 43 and 44 show, the U.S. has become a dominant global producer, particularly relative to some of the more traditional incumbents in recent years.
Low cost natural gas and oil also help to make the U.S. more competitive as an industrial destination. Coupled with Mexico’s cheap labor and Canada’s natural resources, the current recovery is the first one since China joined the WTO in which the U.S. has actually added manufacturing jobs. All told, from January 2010 through July 2015, the U.S. has added 890,000 manufacturing jobs, led by primary and fabricated metals.
U.S. Petroleum and Other Liquids Production Has Surpassed Saudi Arabia…
…And More Natural Gas Is Now Produced in the U.S. Than in Russia
Beyond the innovation initiative that the U.S. has established across several key industry disciplines, the United States also offers a better investment environment in many instances than its global peers, in our view. To be sure, it might not feel this way to many Americans in absolute terms during recent years, but – in our humble opinion – many folks do not fully appreciate how difficult it is to transact overseas. There is certainly no exact way to fully quantify this feeling, but as Exhibit 45 shows, recent World Bank survey data seems to confirm what our “gut” is telling us. Specifically, the U.S. ranks only second to Singapore in terms of being among the most business friendly countries in the world. For our nickel, the U.S. could do even more to extend its position if it became more competitive on corporate taxes.
The U.S. Is Among the Most Business Friendly Countries Globally
Looking at the bigger picture, the U.S. energy industry stands out as a clear example where Americans enjoy an extraordinarily favorable backdrop relative to the competition in terms of ease of doing business. For example, huge portions of the shale discoveries have taken place on private lands, which is essentially a non-starter in many parts of Europe and Asia. Said differently, the American legal and regulatory framework has rewarded the entrepreneur who took creative business risk. Moreover, in many countries heavy government oversight has either disrupted or discouraged private capital from enjoying some of the success that the U.S. energy industry now experiences. Finally, corruption, delays, and lack of resources still often act as much bigger threats to entrepreneurial endeavors outside of the United States than within it.
Reason #6: A Defensible Currency: USD
While we fully acknowledge that a strong dollar may impede export growth in the United States, having a strong currency in an unsettled world is a major asset, we believe. Just consider that the five-year net total return for the MSCI Emerging Market index as of December 2014 was just 11%, as currency deprecation dented gross returns by a full 18% (i.e., the gross return was 29%). Moreover, with China recently letting its currency float, we see more headwinds in this area for non-China emerging markets, as competition for global exports heats up further.
Meanwhile, with the Federal Reserve moving towards short-term rate increases during the next 6-12 months, investors in the United States do not have to worry as much about their core investments being adversely impacted by currency depreciation, we believe. In fact, it could turn out to be an ongoing positive, as the U.S. has clearly emerged as somewhat of a safe haven in recent quarters (Exhibit 46).
We Think That the Dollar Could Have Another Compelling Year as the Bull Market Still Has Room to Run
We See More Upside to U.S. Growth Estimates Than to China Growth Estimates in 2015
The Lion’s Share of Currencies Have Depreciated Against the USD in Recent Years, In Our View
Section IV: Long-Term Investment Implications
As we mentioned earlier, our base case is that the U.S. equity and credit markets may need some time to heal after August’s downdraft. In our view, a pause in U.S. risk assets would be healthy, so that GDP trends can play some form of “catch-up.” That said, we are structurally bullish on the United States and the prospects for long-term investors, and accordingly, we would use any significant market weakness to invest behind key long-term themes and ideas. To this end, we think investors should ponder the merits of the following five investment considerations:
Opportunity #1: Investors Should Consider Gaining Exposure to Companies That Benefit from Increased Household Formation.
From what we can tell, an important inflection point has occurred. Just consider that during the first six months of this year 3.3 million new household formations occurred in the United States, compared to just 1.5 million for all of 2014. Key sectors that should benefit from this acceleration include residential housing, multi-family rental, suppliers, home improvement, and related ancillary services.
Moreover, given ongoing supply constraints, particularly in the rental market, we look for strong trends to continue to support pricing throughout the sector. All told, the national rental vacancy rate has declined to 6.8% in 2Q15, compared to 7.4% in 2Q14 and 11.1% cycle peak in 3Q09. On the construction side, we too are optimistic. In fact, we recently increased our housing starts forecast (Exhibit 49). This increase includes a slight bump-up to our 2015e forecast based on recent strong monthly data; more important, though, is that we made substantial 8-14% increases to our forecasts for the 2019-20e period. Not surprisingly, these out-year revisions are based on our increasing confidence in the outlook for household formation, which we estimate to reach 1.55 million annually through 2020, detailed in“Reason #2”in Section III above.
We Recently Bumped Up Our Housing Starts Forecast, Particularly in the Out Years, Based on Our Increasing Confidence in U.S. Household Formation
Rental Pricing Has Remained Firm, Despite a Sluggish Overall CPI Environment
We See More Pent-Up Demand for Housing and Housing-Related Goods
Housing Wealth Has a Bigger Pass Through Effect on the U.S. Consumer Than Stock Market Wealth
Opportunity #2: We Generally Want Increased Exposure to U.S. Consumer Equities, But Some Selectivity Is Warranted
While we think that the U.S. consumer is in good shape and ready to spend, we think the outcome will look a lot different for consumer-oriented goods companies than it did during the 1990s and 2000s. As long-time senior consumer analyst Greg Melich at Evercore ISI put it to me, “Things are out; experiences are in.” This baton hand-off has certainly been true as it relates to the slowdown we have seen in certain basic retail sales relative to expectations. On the other hand, key areas of relaxation, including recreation, travel, and home improvement all continue to gain momentum, a trend we expect to continue.
Recent Trends in the First Data System Support Our View That Consumers Are Tilting Their Spending Towards Experiences Over More “Stuff”
Healthcare and Consumer Services/Recreation & Travel Now Outpace Traditional Retail Growth in Terms of Consumer Wallet Share
Opportunity #3: Look for Long-Term Investments Linked to Innovation, but Be Disciplined on Valuation
In a world where growth is hard to find, the U.S. market has been rewarding innovation. So much so that folks are now just hoping that some of this innovation leads to positive cash flow dynamics down the road. How else could one explain that 78% of IPOs during the last six months lacked any profitability?
That said, amid some of the hype, there are some really good names across the Biotechnology, Healthcare Equipment, and Services spectrum that have emerged on the scene. Importantly, we look for many of these companies to continue to thrive as Healthcare typically serves as a good late cycle sector (Exhibit 55).
As we look ahead, we believe that recent government initiatives, including Obamacare, favor large players that benefit from increased volumes and low cost production/distribution. Meanwhile, within the drug arena, our experience has been to favor the “arms dealers”, or companies that help to facilitate/improve current innovative techniques already in place, such as pharmaceutical “bio-betters” in insulin production and delivery. Given the robustness of current valuations in the Biotechnology sector, we definitely favor this approach at the moment. Finally, with consumers feeling more flush, more discretionary healthcare expenditures, including beautification and elective surgeries, may likely be on the horizon.
Healthcare Performs Better Later in the Cycle
Consumer Technology Expenditures Are in Secular Growth Mode
On the technology side, we also look for the trend towards mobile to continue to drive technology sales, particularly for platforms that achieve one or more of several important goals including a) helping consumers get what they want with ease and speed, b) helping businesses communicate with and tap those consumers, and c) creating new work opportunities for individuals who have left the traditional, formal labor market out of necessity or choice. We are also particularly watchful for new international investment opportunities that might meet these needs too, as U.S. firms seem likely to gain share in a world where the U.S. accounts for 60% of the top 10 Internet companies, but only 21% of their users.
Opportunity #4: Equity and Credit-linked “Financials” Should Outperform in the Environment We Are Envisioning
Given our bias to own domestic, cyclical stocks outside of the auto industry, financial stocks screen extremely well to us. In particular, we champion large banks, insurance companies, etc., that should benefit from better credit, particularly among consumers. Also, as financial intermediaries pay less to the government and regulators in the form of fines, the potential for both positive earnings revisions and sustainable book value growth increases significantly. Moreover, if we are right that short-term rates are finally headed higher by 2016, then the windfall to profits linked to products like money markets can literally be hundreds of millions of dollars for certain companies if the Fed just boosts rates by 50 basis points.
Legal Fees and Penalties Have Skyrocketed on Wall Street, But We Think the Tide Could Finally Be Turning
Earnings Revisions in Financial Stocks Appear to Be Turning Up
We also look for financials that are boosting buybacks and dividends to be rewarded by shareholders. American International Group has certainly garnered a lot of headlines with this strategy, but we believe that there are a growing number of financial companies that fit this profile.
On the fixed income side, mortgage credit and asset-based lending should perform better than current expectations. We also think private asset-based lending will perform well, and in the semi-illiquid market, we favor some of the new structures out there, including the developing market for credit risk transfer (CRT) bonds. To be sure, this market is nascent, but we believe that it is one that could ultimately be worthy of investor attention.
Opportunity #5: Energy: Time to Sift Through the Rubble to Look for Gems
Though performance has been strong across several parts of the U.S. market in 2015, energy is not one of them. Indeed, as Exhibit 59 shows, the energy exploration and production index that we track (ticker XOP) is down nearly 60% over the last year, with nearly 40% of the drop coming since the beginning of May.
XOP Is Down 58% Over the Last 12 Months and More Than 40% Since the Beginning of May
Implied Volatility in Many Energy Assets Is Now 45-55%, With Near Dated Downside Puts Approaching 65%
We are not particularly bullish that oil prices are headed back higher overnight, but we do believe that value has emerged among both equity and debt securities in the sector. In particular, low cost producers with modest leverage burdens likely represent attractive investment opportunities at this point in the cycle. In particular, we like some of the “busted” convertible structures. From what we can tell, there is the opportunity in the Exploration and Production sector to create double-digit yields with potential equity upside, while staying in a more protected capital position than the straight common.
However, given that the banks that lend to these companies will face a redetermination period in October to reassess the value of the capital that has been lent at higher commodity prices (including both oil and natural gas), we view the energy opportunity as a walk, not run, opportunity in the near term. We also believe that investors should look for value in the master limited partnership arena (MLP). From our vantage point, it appears that some of the more recurring revenue business models such as those that own pipelines and midstream assets have traded down in sympathy with some of the more exploration and production related MLPs, despite their business models being much more durable and predictable.
SECTION V: Conclusion
As I travel around Asia, Latin America, and Europe, it has become increasingly clear to me that the global economy is not functioning as it did in the past. In particular, global demand is not what it used to be, driven by both consumer and government deleveraging. Many EM countries have resorted to weakening their currencies to stoke export demand; however, this initiative has backfired to date, as many EM countries now just face higher import costs without any notable improvement in export levels.
Also, many fast-growing emerging markets are dealing with unusual macro backdrops with extreme inflation differentials. On the one hand, China has experienced 41 months of negative producer price inputs – compliments of falling commodity prices and excess capacity. On the other hand, places like Brazil are enduring the fall-out from excessive credit and poor fiscal policy, both of which have led to outsized inflation differentials versus the United States.
The other major consideration is that the biggest force behind global quantitative easing (QE) is about to change course in 2H15. This repositioning is a big deal, as the Federal Reserve has been a major force of accommodation, with over $4 trillion of assets on its balance sheet.
Against this backdrop, there is little debate amongst individuals on the GMAA team that equity markets are likely to be more volatile moving ahead than they were in the past. We also forecast increased flows out of emerging market equities towards developed equities amid this uptick in volatility. If we are right, then we will have to be more opportunistic than during the 2011-2014 period, including using cyclical weakness like we are now seeing in the U.S. to add to positions.
Regardless of near-term gyrations in the U.S. equity market, we have increased conviction that the United States will garner more attention from global investors in the years ahead, particularly even if we are right that the China Growth Miracle that defined the prior decade continues to unravel. Importantly, though, our confidence in the U.S.’s stature is not just a relative “call.”
In absolute terms, the United States too looks more structurally compelling than it has in years. Key to our thinking is that the U.S. consumer has paid down his or her debts, spent only 60% of what he or she usually does during a recovery, and has a higher savings rate today that is now on par with what he or she had at the beginning of the 2003-2007 economic expansion.
During This Recovery, Consumption Growth Has Been Nearly 35% Slower Than During Previous Recoveries. We Expect This Trend to Change in the Coming Quarters
EM/DM Has Moved in Long Secular Bull and Bear Markets
Innovation is also playing a major role in America’s transformation towards building competitive advantage in key global growth industries. Already, major private sector initiatives across Healthcare, Technology, and Energy Services have allowed the U.S. to transition smoothly towards a strong services-based model with global reach. At the moment, earnings trends in Healthcare and Technology appear the most compelling and broad-based, while the Energy sector likely still requires that an investor sift through some of the recent carnage to find the gems that can deliver significant shareholder returns during the coming years.
Bottom line: we suggest that investors begin to “Lean In” to the U.S. at this point in the cycle. Sentiment is negative, valuations are now reasonable, and earnings growth from Financials, Healthcare, Technology, and Consumer Discretionary should all meet or exceed expectations during the coming 12 months. Importantly, though, given that we are 75 months into an economic expansion and we expect China to remain a wildcard, more volatility is likely ahead, including a potential global earnings recession by 2017 or so.
That said, any significant pullback in U.S. equity markets should be viewed as an opportunity for long-term investors to increase exposure to what we believe is emerging as one of the more interesting country-specific macro stories across the global capital markets in the coming years.
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